Where do Stock Returns Come From? (EP.140)

Episode Summary

Executive Summary: Episode 140 mixed podcast/community updates, book reviews, a deep dive into the anatomy of stock returns and the value premium, a Canadian home-office tax note, and a critique of a Forbes article attacking evidence-based investing. The investing segment argued that returns are driven heavily by valuation changes, portfolio migration, and convergence, which helps explain why recent weak value returns may not imply a permanently lower expected premium.

Main Topics: Podcast/community updates and format changes: The hosts shared listener engagement updates, new store socks, Goodreads/Peloton community connections, upcoming author interviews, and a planned format change alternating investing and financial-planning episodes. Book reviews: coaching and Elon Musk: Benjamin reviewed The Coaching Habit and extracted its seven-question coaching framework; he also praised Elon Musk by Ashley Vance as a revealing biography that changed his view of Musk's background and business trajectory. Anatomy of stock returns and the value premium: The main technical segment examined Fama-French papers on migration and return decomposition, showing that size and value premia arise from a mix of dividends, book-equity growth, and especially convergence/migration effects. Cliff Asness on valuation changes and expected returns: The discussion used Asness's 'The Long Run is Lying to You' to show that historical returns can be misleading if valuation changes are ignored; much of long-run market outperformance came from rising valuations, not just business fundamentals. Canadian work-from-home tax deduction: A practical planning note explained Canada's temporary flat-rate home-office deduction for employees working from home due to COVID-19, emphasizing when the simplified method may be preferable to the detailed method. Bad advice of the week: anti-indexing and anti-evidence-based investing: The hosts criticized a Forbes article claiming evidence-based investing looks backward and that active management is superior, arguing it misrepresents how evidence and scientific reasoning work in investing.

Key Arguments: Most stock returns come from a combination of dividends and capital gains, but the sources of capital gains differ meaningfully across value and growth stocks. Fama and French's migration analysis suggests the size premium is driven largely by a small subset of small stocks that become big stocks, while the value premium comes from migration plus persistent differences between value and growth stocks that do not migrate. The single biggest source of the historical value premium is convergence: value stocks often rise toward neutral/growth valuations, while growth stocks often see valuation compression. Growth stocks can generate strong fundamental book-equity growth yet still post mediocre returns if valuation multiples contract; value stocks can have weak fundamental growth but still earn strong returns if their valuations expand. Cliff Asness argues that long-run historical returns are not good forward-looking expectations unless you account for starting and ending valuations; much of the past return may come from valuation expansion rather than sustainable fundamentals. The recent weak performance of value does not automatically imply that the future value premium is permanently lower; for that to be true, the value spread would need to keep widening indefinitely. Evidence-based investing is not just a backward-looking label; it reflects a scientific approach that tests theories against data, whereas the Forbes critique relied on unsupported assertions about active management. The simplified Canadian work-from-home deduction can be useful and easy, but detailed calculations may still be better in some renting or high-expense situations.

Data Points: Podcast episode: 140 - The episode number of the Rational Reminder Podcast discussed in the transcript. Ratings on iTunes: 484 ratings - The hosts thanked listeners for recent reviews and noted the show had 484 ratings. Listener-supplied machining offer: Custom stainless steel and aluminum battlebot parts - A podcast listener offered to machine upgraded parts for Benjamin's battle bots. The Defiant Ones: 4-episode series - Netflix documentary about Dr. Dre and Jimmy Iovine mentioned in the intro. Apple acquisition price for Beats: Over $3 billion US / $3.2 billion - The documentary covered the Beats sale to Apple. Estimated headphone market share reached by Beats: 20% - The documentary story described Beats reaching roughly 20% market share. Coaching framework: 7 questions - The Coaching Habit was summarized around seven coaching questions. Fama-French migration sample: 1927 to 2006 - Time period used in the migration paper. Size premium explanation: 8% to 12% of small stocks - Fama and French found the size premium was largely explained by the small set of small stocks that became big stocks each year. Value premium contribution from staying in same portfolio: 1% for small stocks; 1.7% for big stocks - Migration paper finding on stocks that remained in the same style portfolio. Plus transitions contribution: 3.5% per year - Improving-in-type stocks contributed to the excess return of value vs. growth portfolios. Minus transitions contribution: 5.1% per year for small stocks; 1.2% for big stocks - Deteriorating stocks were a large drag on growth portfolios, especially among small stocks. Small value total return: 14.44% - 1927-2006 sample comparison in the Fama-French discussion. Big growth total return: 9.18% - Used for comparison against small value. Small value dividend contribution: 3.21% - Part of the return decomposition for small value stocks. Big growth dividend contribution: 3.39% - Dividend contribution for big growth stocks. Small value capital gain return: 11.23% - Return decomposition for small value stocks. Big growth capital gain return: 5.8% - Return decomposition for big growth stocks. Big growth growth-in-book-equity contribution: 10.3% - A major positive driver of capital gains for big growth stocks. Big growth convergence contribution: -5.38% per year - Valuation compression offset fundamental growth for big growth stocks. Small value convergence contribution: 13.45% - Major source of gains for small value stocks. S&P 500 regression R-squared: 93.2% - Asness regression of excess S&P 500 returns on CAPE changes from 1950-2020. S&P 500 excess return over cash: 6.5% - Realized average excess return from 1950-2020 in Asness's analysis. S&P 500 regression intercept: 5.2% - Valuation-adjusted expected return estimate from the regression. CAPE change: 10.9 to 34.5 - S&P 500 CAPE increased from 1950 to 2020. Return explained by valuation expansion: 1.3% - Approximate contribution of rising valuations to the S&P 500 return over 1950-2020. S&P 500 regression ending in 2000: 7.5% excess return; CAPE 45 - Asness showed a larger valuation contribution when ending at the tech bubble peak. International developed equity outperformance by US: 2.1% per year - US vs. EAFE return difference from 1980-2020 in Asness's analysis. Value premium regression R-squared: 78.8% - Asness regression using value spread and HML Devil. Value premium regression intercept: 3% - Valuation-adjusted expected value premium from 1950-2020. Realized value premium: 1.9% - Unadjusted historical value premium over the same period. 1990-2020 value premium: 0% realized; 1.6% intercept - Post-publication period often cited as evidence that value is dead. Temporary home-office deduction: $2 per day - Canadian simplified flat-rate deduction for eligible employees working from home in 2020. Eligibility threshold: More than 50% of the time for at least 4 consecutive weeks - COVID-related home office expense deduction criteria.

Pivotal Quotes: "The long run is lying to you." — Cliff Asness: Title and central thesis of the valuation-adjusted expected return discussion. "It's easy to talk about the discount rate and talk about the risk-based story ... but then where does the return actually come from?" — Benjamin Felix: Framing the core question behind the anatomy of stock returns segment. "Evidence-based investing is like an accident waiting to happen. It's what happens when you drive from the third row looking backward." — Forbes article quoted in the bad advice segment: The hosts cited this as an example of misleading criticism of index/evidence-based investing.

Implications: Listeners should be cautious about using raw historical returns as forecasts; valuation changes matter. For investors, the value premium may still exist even after recent underperformance. For Canadians, the simplified work-from-home deduction could save time and taxes, but details still matter.